Kevin Hebner

US equity market strength over the past year has been driven by the magnificent seven and artificial intelligence (AI) players, and this trend is set to continue into 2025 and beyond, according to Dr Kevin Hebner, global investment strategist at Epoch Investment Partners, fund manager partner of GSFM.

But he says it is not a trend that can continue indefinitely.

“The consensus expectations for earnings growth this year for the entire S&P 500 is 12 per cent, but that is just an average, and for 493 companies it’s only 5 per cent, roughly in line with nominal GDP growth. For the magnificent seven it is 55 per cent.

“We have this enormous dichotomy that’s being driven by the build out of infrastructure to support AI. These are all the picks and shovels, including the compute, the clouds, and the semiconductors, that make up the operating stack.

“This is going to drive earnings certainly through 2024 and into 2025, but beyond this is less certain,” he says.

Looking more broadly at the magnificent seven, Dr Hebner believes there are three reasons to think we may be in the midst of an AI bubble, similar to the tech bubble in the late 1990s.

“There is enormous concentration in terms of stock market cap for a small number of stocks, valuations are extreme and there is a euphoria of public comment driving prices.

“It’s always the case that there are titans. Titans rise and titans fall and over the past 30 years there has been a lot of movement in the top 25 tech companies, with the exception of Microsoft and maybe Apple.

“With a disruptive technology like AI it is not clear which ones will or will not be able to pivot or adapt, which is why I don’t think it makes sense just to go out and buy the incumbents, particularly now when there are several reasons to believe that we are in the early stages of an AI bubble.

We are only at the beginning of a new age of new technologies for consumers and businesses – and it is a decade-plus long process. Dr Hebner says it’s not yet clear which aspects of AI will actually add economic value to businesses and households, similar to the experience with previous general-purpose technologies (GPTs).

“A decade may sound like a long time. But looking at the experience with previous GPTs – such as the internet or electricity – it did take a long time to see the economic value-add. So investors will need to be patient.”

AI has already seen success in areas including coding and marketing copy, however Dr Hebner believes that healthcare and education are sectors which will benefit the most from AI.

“Healthcare represents about 20 per cent of GDP and is one area where we hope AI will have a substantial impact, even though it is highly institutionalised and resistant to change. We can see positive impacts in areas such as diagnostics or drug discovery.”

“Similarly we see education as another big beneficiary of AI. We are already starting to see these positive impacts.

“We’ve also seen unconventional applications of AI, one of which I like the most is from agricultural equipment company, John Deere. It has made inroads with its combine harvester, a labour saving machine designed to cultivate seeds. The company now has more software engineers than it does mechanical engineers.

“The combines they produce perform numerous tasks across a field such as seeding, fertilising and de-weeding. The combines test the soil by taking samples and access the quality of the soil and what tasks need to be performed. All these tasks are performed using satellite GPS, so drivers aren’t even needed to navigate these machines.

“John Deere is a very interesting case of a traditional company trying to pivot and become an AI company.

“AI augments our abilities, and it is going to make us better. We need to embrace it in the same way that we needed to embrace PCs and the internet and appreciate how they would help us do our job even better.

“Companies that invest in AI to achieve efficiencies and cost savings, are the ones that are on our investment radar,” he says.

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Kevin Hebner

Policymakers face a significant challenge in regulating artificial intelligence (AI) as innovations quickly expand while citizens demand action to ensure AI applications don’t endanger their safety, according to Dr Kevin Hebner, managing director, global investment strategist with Epoch Investment Partners.

Given the market imperative, big technology companies have turbocharged their AI efforts to ensure they are on the front of the wave, more interested in speed than safety. Given the economic imperative to be first, it is not surprising the public wants increased transparency and is supporting increased regulation. However, regulators should not act too quickly to clamp down on AI, according to Dr Hebner.

“The track record of regulation suggests one major risk is a rush to action, without the benefit of rigorous cost-benefit analysis and a firm understanding of how the technology is evolving. As often occurs, regulators would inflict a lot of harm in their vain attempt to do a little good,” Dr Hebner said in a new whitepaper, AI: How to Regulate an Emerging Tech?

“A second risk is strangling innovation, as frequently transpires in Europe, while a third is regulatory capture, which seems likely given the high stakes and dearth of AI expertise in government,” he said.

According to Dr Hebner, a balance needs to be struck between encouraging innovation in AI and ensuring safety for citizens. The US is usually much better at this than Europe, which has stifled innovation through regulation.

“This helps explain why most of the top AI professionals are based in the US or Canada even though they were born abroad. It also clarifies why America captures the lion’s share of private sector investment in AI,” he said.

“Mistakes will be made, and they will have important implications for the evolution of AI, the structure of the industry and the cash flow earned by investors. Implementing a rigid and complex regulatory framework is likely to impose excessive costs but do little to protect society. Unfortunately, such an outcome seems highly likely given the political pressure to act, even though we have little idea what the AI ecosystem is going to look like just a few years down the road,” he said.

The whitepaper notes that populations globally are apprehensive about AI and demanding regulation.

“Regarding the economic impact of AI, most people are concerned it could eventually replace their jobs and result in further concentration and power in the technology sector. On a more positive note, many people are optimistic AI will improve the quality of services they receive, especially in healthcare.”

But caution is needed before laws are made to regulate the unknown. “Nobody possesses a crystal ball and we do not know which start-up companies will become the next titans, and which current superstars will fall. This level of uncertainty means we are regulating what we do not really understand, which is, which governments need to be cautious now about introducing restrictive laws.

When it comes to investing in AI for long term returns, Dr Hebner says only a small number of companies will be winners, and will successfully capture the value inherent in AI.

“Nevertheless, we have previously said we view AI as the fourth wave of digital technology after the PC, internet and mobile phones, and this view hasn’t changed.

“We believe AI will be the key driver of equity markets over the next decade, significantly impacting the labour market, productivity and sector concentration, as well as margins and free cash flow generation,” Dr Hebner says.

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Kevin Hebner

Occupations most likely to be impacted by artificial intelligence (AI) are white-collar jobs, including well paid positions requiring high levels of formal education. On the other hand, the jobs least exposed include manual tasks which AI-enabled robots can’t as easily replicate, according to a new white paper from GSFM fund manager partner Epoch.

Dr Kevin Hebner, managing director, global investment strategist with Epoch, said AI will be highly disruptive to labour markets overall, though it will also bring substantial efficiency gains to companies and economies.

“While jobs are not going to disappear, around 60 per cent of tasks and occupations in the US will be changed materially by AI over the next two decades. We expect overall employment and real wages to rise but that will be accompanied by dramatic shifts across vocations. Furthermore, high wage sectors are the most exposed to AI,” says Dr Hebner.

The white paper finds that occupations most likely to be impacted by AI are those involving cognitive functioning and formal education rather than jobs involving manual work. These occupations include lawyers, post-secondary teachers, real estate brokers, personal finance advisers and content creators such as journalists and computer code writers. In contrast, occupations with low exposure to AI include trade jobs such as painters, plumbers, electricians and welders, as well as cleaners.

“Those with the lowest exposure to AI feature physical skills that will remain beyond the aptitude of AI-enabled robots for the foreseeable future,” the whitepaper reports.

Following from that, workers’ cognitive skills and IQ could become less important as AI replaces these skills and they could become relatively cheap over time. In contrast, soft skills could become more important as AI can’t as easily replace them.

“The key worker skills likely to be beneficiaries of this change could include empathy, relationship skills, artistic creativity, and athletic exceptionalism,” says Dr Hebner.

In contrast, AI will effectively replace the skills of workers involved in technical and repetitive tasks such as content production, customer support, writing and coding, but not perfectly.

“AI will reduce the cost of creating content toward zero. However, truly exceptional code, writing, music, or videos will remain beyond the realm of AI for at least the next decade. In the meantime, prepare to be overwhelmed by mediocre content of every sort,” says Mr Hebner.

For employers, AI is unambiguously positive, as it is increasing opportunities for efficiency gains and innovation. AI is expected to increase US productivity by 20 per cent over the next two decades.

“While this is a very rough guess, we can be more certain that a relatively small share will come from efficiency gains (doing things we already do, but with a bit less labour), with the lion’s share generated by innovative new products and services, many of which will astound and befuddle us all,” the whitepaper finds.

In terms of investment implications, only a small number of companies are expected to capture most of the value created by AI, especially those businesses which develop a dominant position in the provision and application of AI.

“Business strategies for the digital age are capital light, which is positive for margins and shareholder yield. This is especially for true for companies that establish themselves as global champions in the AI era,” says Dr Hebner.

However, he adds we are likely to see increased concentration in most sectors.

“We view AI as the fourth wave of digital technology after the PC, internet and mobile phones, with each stage having a progressively greater impact on the labour market, productivity, sector concentration, and free cash flow (FCF) generation,” the whitepaper says.

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Kera Van Valen

2023 has seen AI mania captivate investors, as a year-to-date bull run in global equities has been fuelled by rampant speculation on the future growth implications of the technology’s broad adoption however rising market indexes paint a somewhat misleading picture, says Kera Van Valen, portfolio manager for the Global Equity Shareholder Yield strategy at Epoch Investment Partners (TD Epoch).

The year’s rally has been remarkably concentrated, being largely confined to just a handful of mega-cap tech companies,” Van Valen says.

“Recent years have seen these firms’ index weights balloon alongside their price multiples and market caps; for example, Microsoft and Apple now make up nearly 10 per cent of the MSCI World Index, which is composed of over 1,500 stocks. High index weights coupled with outsized returns have led to just 7 stocks accounting for over 50 per cent of the MSCI World’s return through the end of the second quarter.”

Van Valen says the narrow market leadership poses a relative performance challenge for diversified equity managers.

“Indices meant to be representative of the broad market have seen their return profiles skew due to these concentrated position sizes, which presents difficulties for managers like us who emphasise the benefits of diversification in their risk framework and portfolio construction process.”

Managers who are focused on income have found the year’s market environment less supportive as well, says Van Valen.

“From an income perspective, it’s difficult since most of the tech companies leading this AI rally are growth oriented and don’t pay dividends.”

That said, while the AI trend has rewarded a small cohort of tech stocks most sharply, there are other pockets of the market benefitting from the theme. Van Valen notes that her portfolio is not absent exposure to AI and has seen ample participation in the year’s rally; however, she highlights the importance of not losing sight of fundamentals.

“The stocks that have been centre stage during this rally have seen their valuations skyrocket based largely on lofty expectations of future growth; however, there is limited fundamental backing right now. It will be important to watch how earnings unfold over the next several quarters.”

The Global Equity Shareholder Yield Fund’s positive net absolute return this year has been driven largely by its holdings in the information technology sector. The fund focuses on owning fundamentally strong, highly cash generative firms that prioritize returning cash to shareholders, and holdings that are thematically linked to AI are no different.

“One portfolio holding with exposure to the AI theme is Broadcom, a designer and manufacturer of digital and analog semiconductors focused on connectivity. The stock has benefitted from growing expectations for needed investment in networking to support nascent use cases surrounding generative AI. The company returns cash to shareholders via an attractive dividend with a target of paying out 50 per cent of free cash flow.”

Despite the buzz and market chatter, investors should remain cautious when chasing the most crowded AI trades that have already seen valuations pushed to precarious levels. Given the current macro-economic environment—with political uncertainty in the US, high inflation and interest rates, the likelihood of a recession, and the ongoing Russian-Ukrainian war—Van Valen believes the most reliable and best source of returns will likely be shareholder distributions.

“Companies that will outperform are those with strong market positions, a track record of maintaining and growing cash flow through economic cycles, pricing power and the ability to defend margins. We also look at corporate balance sheets that reflect high liquidity levels to support dividends and share repurchase capability.

“While earnings will likely be pressured by the current macro-economic backdrop, companies that hold these characteristics should prove capable of maintaining earnings growth despite the volatile environment,” says Van Valen.

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